Of Computers and Cronyism: What’s the Cause of Italy’s Productivity Problem?

The latest Stigler Center working paper from Bruno Pellegrino and Luigi Zingales argues that Italy’s sclerotic TFP growth over the past two decades has stemmed from the inability of its meritocratically challenged management to take full advantage of the ICT revolution.

Economists started worrying about Italy’s poor productivity numbers long before the IMF warned last year that the country is currently verging on two “lost decades” of growth. Hard-hit as the country has been by the financial firestorm of 2008—with IMF forecasts showing it unlikely to fully bounce back from the crisis until the mid-2020s—Italy’s problems stretch back much further to the mid-1990s. In their latest Stigler Center working paper, Bruno Pellegrino and Luigi Zingales [Faculty Director of the Stigler Center and one of the editors of this blog] offer evidence linking one of the most alarming symptoms of this “Italian disease”—the country’s near-stagnant total factor productivity growth—with a lack of meritocracy among managers that has prevented firms from capitalizing on the information and communication technology revolution.

Productivity in Italy began to trail behind that of other developed countries in the mid-1990s, with growth in output per hour worked during 1996–2006 reaching just 0.5 percent, compared to Germany at 1.7 percent, France at 1.9 percent, and the United States and Japan at 2 percent. But while some of the institutional dysfunctions for which Italy stands out among other rich countries might explain some of this lag, Pellegrino and Zingales are more interested in probing why Italy’s productivity suddenly dropped off relative to its own historical performance in the decades prior. Growth in Italian TFP (which measures the part of output not accounted for by production inputs—in other words, how efficiently inputs are being used) hit a wall in the mid-1990s, during what was otherwise a period of relative economic stability.

Economists have advanced several ideas on what caused this unraveling of Italian productivity growth after its steady climb up until the early 1990s. In their working paper, Pellegrino and Zingales take on various competing hypotheses—that trade shocks, inflexible labor markets, or just plain bad governance is what has been hurting growth—before turning their attention to another shock that swept across the developed world at that time: the digital revolution. They are particularly interested in the literature on ICT complementarity, that is, how ICT investments can interact with certain firm characteristics to either bolster or dampen productivity.

One after another, the authors discard hypotheses on the Italian productivity decline by marshalling a rainbow of different data sets for their needs. The root of the problem is not, they say, due to shocks to trade after China’s entry to the WTO or Italy’s integration into the eurozone: in fact, sector-level EU-KLEMS data reveal that Italian industries with greater exposure to China as measured by OECD and WTO data did no worse on TFP growth than less exposed industries.

Nor does it appear that the problem is that Italy’s rigid labor markets have been keeping people from moving into the right jobs: sectors where workers experienced mass layoffs (as captured in the CPS Displaced Worker’s Supplement) during the same period in the United States, with its extremely unprotected labor markets, did not do worse on TFP growth in either Italy or other countries that score high on a composite index of labor law strictness.

And while the decline in Italy’squality of government, as measured by the Rule of Law Worldwide Governance Indicator over the period in question, is obviously quite a serious problem, it seems not to be the root of the Italian productivity problem, or at least not directly. The authors test for a relationship between TFP slowdown and a sector’s level of dependence on the government using a dataset they put together themselves from the Factiva news search engine, and conclude that decaying governance quality is not what’s sapping productivity growth.

Among the competing explanations for the Italian productivity problem, Zingales and Pellegrino see the most potential in shocks from the ICT revolution that took off in the mid-1990s. The rest of their paper probes the mechanism whereby ICT capital might yield productivity growth and why it has not done so in the Italian case. Other research has examined how Italy’s delay in jumping on the ITC bandwagon hurt productivity. But here Pellegrino and Zingales follow other researchers who’ve found that, on its own, simply investing in ITC is not enough: Garicano and Heaton (2010), for instance, found that IT increases do not necessarily make workers more productive in the absence of specific management and organizational practices and the sorts of “intangible assets” described by Brynjolfsson et al. in 2002 and elaborated upon by Bloom et al. in 2012.

One such asset on which previous research has found Italian firms run conspicuously short is meritocracy. Most Italian firms make human resources decisions—whom they hire, fire, promote, and reward—based on loyalty rather than merit. Loyalty-based management can work well for firms operating in contexts with weak legal enforcement and widespread corruption, but it is often poor at embracing, deploying, and capitalizing upon new information technologies. As the authors put it, “A reasonable explanation is that, at the onset of the ICT revolution, Italy found itself with the wrong type of management system to take advantage of these newly available technologies.” In other words, the interaction between meritocratic management and ICT investment is the ground on which Italian productivity came to die.

To disentangle the possibility that other country-level institutional features correlated with meritocracy might be what is actually at work here, the authors measure meritocracy at both the firm level (with EFIGE data) and the country level (using the WEF Global Competitiveness Report Expert Opinion Surveys). They find a positive correlation between EU-KLEMS sector-level TFP growth numbers and an interaction term capturing level of meritocratic management and ICT capital—not just in the Italian case but across the countries in their sample.

Figure 2: Productivity growth around the ICT revolution at the industry level.1)Original figure notes: “This figure displays the evolution of TFP estimates, indexed at 1995, from the EU KLEMS database for different country/sector groups. We sort high-Meritocracy versus low-Meritocracy countries (top tercile versus bottom tercile based on our country-level measure of meritocracy) and high ICT intensiveness versus low ICT intensiveness sectors (top eight versus bottom eight sectors based on the sector-level, cross-country average contribution of ICT capital to output growth in 1995–2006). We take the median TFP growth rate for each group/year, giving equal weight to all country/sectors.” Source: Pellegrino and Zingales, 2017

As figure 2 shows, in non-meritocratic countries, sectors that invested less in ICT capital showed higher levels of TFP growth than ones that spent more on ICT. Money spent on ICT is clearly no magic bullet for boosting productivity in the absence of the appropriate management styles. In the Italian case specifically, the estimated magnitude of the effect is rather breathtaking: at least half of Italy’s TFP gap can be accounted for by this interaction between ICT and meritocracy.

The obvious question that emerges, then, is why Italy should continue to cling so stubbornly to a management style that has been dragging down the country’s growth numbers for decades. In answering it the authors circle back around to one of the factors they started with: Italy’s shoddy institutions. The authors are careful to use positive language in assessing when loyalty-based management can be optimal: in the face of Italy’s inefficient legal system and problems with corruption, it seems this management style can still get things done.

But they step away from the euphemisms when delivering their final, damning diagnosis of Italy’s productivity problem: “Familyism and cronyism,” they conclude, “are the ultimate cause of the Italian disease.”

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Original figure notes: “This figure displays the evolution of TFP estimates, indexed at 1995, from the EU KLEMS database for different country/sector groups. We sort high-Meritocracy versus low-Meritocracy countries (top tercile versus bottom tercile based on our country-level measure of meritocracy) and high ICT intensiveness versus low ICT intensiveness sectors (top eight versus bottom eight sectors based on the sector-level, cross-country average contribution of ICT capital to output growth in 1995–2006). We take the median TFP growth rate for each group/year, giving equal weight to all country/sectors.”